Up in smoke: Inaction on tobacco bills, lax enforcement proves costly for state

Sep. 29, 2013

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Missouri’s tobacco money

$130M Expected 2014 payment$70M Amount lost$8.2B State budget

Highlights of the Arbitration Ruling“Distributors reported that 432 million (non-participating manufacturer) cigarettes were stamped and sold in Missouri in 2002. State records indicated that NPMs deposited escrow on 102 million of those cigarettes in 2003. This resulted in a collection rate of 24%. Missouri did not question these numbers.” *** “Despite the fact that escrow was not paid on over 300 million NPM cigarettes reported to the State by distributors and that most of the NPMs selling in Missouri did not pay the escrow they owed, Missouri did not file any lawsuits in 2003. Further, it took no action on the pending suits filed in prior years.” *** “It is uncontroverted that no field audits were conducted in 2003 despite the Department of Revenue’s suspicion of underreporting. The importance of these field audits was also recognized by the Department of Revenue’s repeated requests for more resources, in part to audi these suspicious distributors. Nevertheless, the Legislature repeatedly turned down these and numerous other requests, while at the same time granting approximately one million dollars to establish a ‘do not call’ registry.” *** “The record demonstrates that NPM non-compliance was extensive and that it persisted throughout 2003, with NPMs continuing to sell large volumes of cigarettes without having paid the escrow due on them.”

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Jay Nixon urged the General Assembly to pass it.

Lawmakers did not.

Chris Koster told them the legislation was urgent.

Still, it was not approved.

Year after year, then-Attorney General Nixon and current Attorney General Koster told lawmakers they needed to pass a bill that would help shield the state from the potential loss of millions of dollars in cash from tobacco companies.

The General Assembly chose not to act, eventually leading to the state having to submit to arbitration over whether it “diligently enforced” its tobacco laws for the year 2003.

On Sept. 11, a panel of three former federal judges ruled against Missouri and other states in a lawsuit brought by more than 30 cigarette manufacturers.

The state could lose up to $70 million next year.

Though lawmakers did not heed the calls for action from Koster and Nixon, the reasons Missouri ultimately lost the suit are numerous and involve multiple players.

The arbitration panel cited the following factors in its decision:

• Missouri, under then-Attorney General Nixon, did not sue certain cigarette manufacturers in 2003 to force them to pay into a special escrow fund as required by state law.

• Only 24 percent of those certain manufacturers made the required escrow payments in 2003, the lowest percentage of any state involved in the arbitration ruling.

• The escrow payments were supposed to be based on the number of cigarettes sold. Although Missouri suspected certain cigarette makers were under-reporting sales, no field audits were conducted to determine if this was the case.

Without the legislation advocated by Nixon and Koster, Missouri was unable to settle with the tobacco companies — as many other states did — and had to allow the arbitration panel to rule instead.

Leveling the playing field among manufacturers

The saga begins with 1998’s Master Settlement Agreement, the landmark $200 billion ceasefire between big tobacco and the states. Missouri was one of the original signatories to the agreement.

The agreement came after the vast majority of states sued major tobacco manufacturers such as Phillip Morris and R.J. Reynolds, claiming the health damage cigarettes inflicted upon people was damaging state coffers as governments were forced to deal with the health consequences of smoking and the increased costs to state health programs, such as Medicaid.

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Faced with a barrage of lawsuits, the companies entered into the agreement with the states. At its core, the agreement shielded tobacco companies from future lawsuits. In turn, the companies agreed to compensate the states for decades into the future.

However, the story does not end there. As the years wore on, another player in the drama emerged: the non-participating manufacturer.

The tobacco manufacturers that negotiated with the states back in the ’90s are known as participating manufacturers. The non-participating manufacturers include everyone else. These companies did not settle with the states and are under no obligation to make annual payments as part of the MSA.

Because the non-participating manufacturers are not making annual payments as part of the MSA (which are in the billions of dollars each year), those companies have a potential competitive advantage over the participating manufacturers.

The states and the participating manufacturers anticipated this issue when they hammered out the MSA. The agreement holds out the possibility that the participating manufacturers’ payments can be reduced if the companies can prove their competitive disadvantage has harmed them and that the states have not taken steps to eliminate the disadvantage.

To counteract that disadvantage, all states in the MSA passed laws forcing non-participating manufacturers to pay into an escrow account according to the number of cigarettes it sold in that state each year.

The money remains in escrow for 25 years to pay for any judgments against the non-participating manufacturers in lawsuits brought by the state. In the meantime, it also serves to level the playing field between participating manufacturers and non-participating manufacturers.

This did not work entirely according to plan, as the arbitration ruling points out.

“The Settling States all enacted Escrow Statutes following the MSA. But following the signing of the MSA in 1998, and despite the Settling States’ universal enactment of Escrow Statutes imposing payment obligation on NPMs, the NPMs’ market share increased at significant rates.”

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Basically, the escrow accounts were not enough to snuff out the advantage the MSA gave to non-participating manufacturers, and, in fact, the non-participating manufacturers only continued to gain ground.

So, in 2005, the participating manufacturers began a process that eventually resulted in the Sept. 11 arbitration ruling.

States had a number of options available to try to mitigate the non-participating manufacturers advantage, including suing those who were not paying into the escrow accounts and limiting sales of non-participating manufacturers’ products in proportion to those payments.

It also included passing legislation that closed loopholes that made enforcing the escrow law difficult.

The first, known as “Complementary Legislation,” required any non-participating manufacturer selling inside the state to have a registered agent in the state for the purpose of legal process.

“Prior to the 2010 passage of Complementary Legislation, NPMs were not required to identify their own product brands, or name a registered agent in Missouri for service of process — requiring the state to investigate each brand in order to identify the manufacturer, and then find a way to obtain service of process for manufacturers in countries like Nepal, Brazil, and the Philippines,” Koster told the News-Leader.

The second, “Allocable Share Release Repeal,” (ASR Repeal), stopped non-participating manufacturers from avoiding their escrow payments by concentrating sales in a few states, Koster wrote to lawmakers.

Koster annually urged lawmakers to work to close the loopholes. Before him, Nixon did the same.

Missouri the only settling state not to take action

Did Missouri pass both bills? No.

It did pass Complementary Legislation in 2010. However, it has yet to pass ASR Repeal.

Missouri is the only settling state that has not passed the ASR Repeal, though lawmakers have filed bills during past years.

“To date, Missouri is the only settling state in the nation that has failed to pass any aspect of this proposed legislation,” Nixon wrote in 2006.

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Rep. Eric Burlison, R-Springfield, said lobbyists from participating tobacco companies have tried to persuade him Missouri needs the legislation.

“They came into my office and they said this is not fair, we do not have fair competition with these new entrants,” Burlison said.

But Burlison said his philosophy is that because some of the non-participating manufacturers did not exist when the MSA was signed, they should not have to suffer the consequences.

A number of ASR Repeal bills have been introduced. The current House majority leader, Rep. John Diehl, R-Town and Country, has introduced the bill in previous years.

So has Sen. Kurt Schaefer, R-Columbia, who has announced his candidacy for attorney general. He suggested some lawmakers had been waiting to see the outcome of the arbitration case before making up their minds about the legislation.

“I wouldn’t be surprised if some people didn’t have a let’s wait-and-see attitude to see if this was really something that needed to be addressed,” Schaefer said.

In a January 2013 letter to legislative leadership — House and Senate majority and minority leaders, Speaker Tim Jones as well as Gov. Nixon — Koster wrote that he estimated an “even chance” that the arbitration panel would find the state did not “diligently enforce” its law in 2003 and that the legislature and the governor should “proceed with caution” in appropriating 2014’s tobacco payment.

Twenty states settled last December. Six, including Missouri, went before the arbitration panel.

In ruling against Missouri, the panel noted that distributors reported 432 million non-participating manufacturer cigarettes were sold in Missouri in 2002. But the manufacturers only deposited escrow on 102 million of those cigarettes in 2003.

“This collection rate of 24% using Missouri’s own numbers, was the lowest collection rate among all the states whose diligent enforcement is now being decided,” the ruling says. “While not a precise comparison by any means, it is still worth noting that the collection rate for the uncontested Settling States was reputed to be 79%.”

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The panel also found Missouri did not try to do much about it and filed no lawsuits against non-participating manufacturers in 2003. Additionally, the state did not take any action on lawsuits it had filed in previous years.

Nixon was attorney general at the time and would have been in a position to file suit against manufacturers.

In his 2006 letter to lawmakers urging them to pass the ASR repeal, Nixon defended his past enforcement efforts.

“Missouri has been a national leader in enforcing its NPM statute. We were the first state to file a lawsuit against an NPM, and have since assessed nearly $17 million in escrows and more than $11 million in penalties,” Nixon wrote.

According to the arbitration ruling, Missouri argued that lawsuits in 2003 would have been futile. The panel notes that “no contemporaneous evidence supports the argument” the state made.

Nixon spokesperson Scott Holste did not provide a response to a News-Leader inquiry about Nixon’s actions as attorney general.

The panel’s disappointment extends to the General Assembly as well. The ruling says no field audits of cigarette distributors were conducted in 2003 despite testimony by Patricia Gifford, who retired in 2004 as the Missouri Department of Revenue’s excise tax manager, that she suspected under-reporting of non-participating manufacturer cigarettes.

“The importance of these field audits was also recognized by the Department of Revenue’s repeated requests for more resources, in part to audit these suspicious distributors. Nevertheless, the Legislature repeatedly turned down these and numerous other requests, while at the same time granting approximately one million dollars to establish a ‘do not call’ registry,” the ruling says.

In the end, the panel found that Missouri did not diligently enforce its escrow law in 2003, a decision that will ultimately cost the state about $70 million.

What's next?

Although arbitration over enforcement in 2003 is over, it is possible that the state could eventually face a challenge over its actions in subsequent years.

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Schaefer said it is likely arbitration on other years will move forward and added he plans to file the ASR Repeal bill again. Now that the state has lost one round of arbitration, Schaefer said he suspects the outcome may change some minds on the need for his legislation.

“I do believe that, legally, to protect the state of Missouri, there is an absolute need to pass that fix on allocable share,” Schaefer said.

Koster said passing the ASR Repeal remains necessary.

“Aside from the policy considerations of ensuring money in an escrow account for any future state claims against an NPM, closing the loophole by enacting ASR would provide Missouri with the ability to participate in settlement negotiations of future cases,” Koster told the News-Leader.

Linda Luebbering, Missouri budget director, said the Fiscal Year 2014 budget assumed the state would receive about $130 million, the normal amount, in settlement money in April.

The first $35 million goes toward funding early childhood programs, Luebbering said, adding that funding is set out in statute and should be fine.

“The rest of it largely is used to fund various Medicaid payments,” Luebbering said.

Luebbering said most people likely will not experience any change because of the $70 million shortfall. Though $70 million is a significant amount of money, for context, the state’s general revenue budget is $8.2 billion.

The prospects that Missouri will get any of that money back are slim.

“The MSA contains no provision for appealing the decision of the arbitration panel,” Koster told the News-Leader. “Under federal arbitration law, the basis for any appeal of a decision is extremely limited. We have filed a motion in circuit court to vacate the decision of the arbitration panel, and that motion is currently pending.”

Vince Willmore, spokesperson for the Campaign for Tobacco Free Kids, said there is one way the state can bounce back from arbitration.

“Missouri can make up any money it loses on arbitration by raising its tobacco taxes,” Willmore said, adding it’s a health and revenue win.

Missouri has the lowest tobacco tax in the nation, at 17 cents per pack. Multiple attempts to raise the tax in recent years have failed, rejected by voters.

Most recently, voters turned down, 51 to 49 percent, a November 2012 proposal to raise the rate to 90 cents per pack.